Smart Beta ETFs Tilt Target Date Funds

Asset managers have been advocating the usage of index-based products focused on minimum volatility, quality, momentum and other factors in recent years, suggesting that these were better ingredients for portfolio construction.

In recent months, some of them have taken the logical next step and put these smart-beta products to use in their own kitchens.

In November 2016, BlackRock renamed its “LifePath Active” target-date series “BlackRock LifePath Smart Beta,” and reconstructed the portfolios to incorporate the funds’ minimum volatility and multifactor U.S. and international equity ETFs as well as its own fixed-income ETFs.

Target Date Dictates Exposure

The exposure to equity and fixed-income asset classes, as well as the use of factor products, differs depending on the target-date year.

For example, at the end of April, the BlackRock LifePath Smart Beta 2020 Fund (BAPCX) had 38% of assets in EFAV and USMV, and 12% in INTF and LRGF. In contrast, the BlackRock LifePath Smart Beta 2040 Fund (BAPHX) had 61% of assets in INTF and LRGF, but 20% in these two minimum-volatility products.

Equity Factor Exposure in BlackRock LifePath

Source: BlackRock, April 28, 2017

Added Value Unclear

Aided by these lower-cost ETF holdings, both BAPCX and BAPHX have below-average expense ratios relative to their Lipper target-date peer groups, consisting primarily of mutual funds that hold individual stocks/bonds or other mutual funds. CFRA thinks the track records for the BlackRock funds under the current strategy are too short to assess whether the portfolio changes have added value.

Meanwhile, PowerShares launched a suite of asset allocation ETFs in February based on a targeted exposure to equities and fixed income, using PowerShares low-volatility ETFs as well as other PowerShares fundamentally constructed ETFs. Asset allocation is handled by Invesco.

The largest equity ETF holding for PSMG and PSMM is the PowerShares FTSE RAFI US 1000 Portfolio (PRF), which focuses on stocks with dividend and certain value attributes. PSMM and PSMG have expense ratios of 0.38% and 0.39%, respectively.

Frank Nielsen, managing director of quantitative research for Fidelity’s Strategic Advisers (SAI), concurs that there are diversification benefits to combining factors. Most factor returns generally are not highly correlated with one another.

In mid-2016, Fidelity SAI began offering managed accounts using passive strategies as building blocks. Examples of these include mutual funds Fidelity SAI US Minimum Volatility Index Fund (FSUVX) and Fidelity SAI US Quality Index Fund (FUQIX), which are not open to new investors. These are built differently than the recently launched and more accessible Fidelity Low Volatility Factor ETF (FDLO) and the Fidelity Quality Factor ETF (FQAL).

According to Nielsen, when comparing index-based products, it is important to understand how the indices are constructed, e.g., what is the universe of securities; what is the definition of the factors; what is the index construction methodology, and how does that impact the sector exposure and index performance.

Of this quality index quartet, FUQIX had the highest exposure to information technology stocks (37% of assets), tracking a nonsector neutral MSCI index, while SPHQ had the greatest weighting in consumer staples (18%).

Sector Exposure in Quality Index Funds Differs

Source: CFRA’s MarketScope Advisor, March 31, 2017

Not surprisingly, year-to-date through May 12, FUQIX’s 9.6% gain was ahead of FQAL (7.1%), QUAL (6.5%) and SPHQ (6.0%).

In ranking ETFs and mutual funds, independently, costs and what’s inside the portfolio matter more than performance record. Asset allocation products that hold a firm’s own mutual funds are highly common. Yet as index-based factor strategies become more accepted by investors, we expect more firms will launch asset allocation products using these targeted offerings as the constituents.

Reports on these ETFs and mutual funds can be found on MarketScope Advisor and other platforms on which CFRA research is available.

At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at [email protected]. Follow him at @ToddCFRA.